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Entrepreneurial Finance
FOURTH EDITION
J. CHRIS LEACH
The University of Colorado at Boulder
RONALD W. MELICHER
The University of Colorado at Boulder
Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States
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Entrepreneurial Finance,
4th Edition
J. Chris Leach, Ronald W. Melicher
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Jack W. Calhoun
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© 2012, 2009 South-Western, Cengage Learning
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To my wife Martha, our great joys Laura and John, and the Life we share
J. CHRIS LEACH
To my parents, William and Lorraine, and to my wife, Sharon, and our children, Michelle,
Sean, and Thor
RONALD W. MELICHER
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Brief Contents
PART
1
Background and Environment
1
CHAPTER
1
Introduction and Overview
CHAPTER
2
From the Idea to the Business Plan
PART
3
37
2
Organizing and Operating the Venture 79
CHAPTER
3
Organizing and Financing a New Venture
CHAPTER
4
5
Measuring Financial Performance 119
Evaluating Financial Performance 151
CHAPTER
PART
81
3
Planning for the Future 187
CHAPTER
6
Financial Planning: Short Term and Long Term
CHAPTER
7
8
Types and Costs of Financial Capital 231
Securities Law Considerations When Obtaining Venture Financing
CHAPTER
PART
189
269
4
Creating and Recognizing Venture Value 313
CHAPTER
9
CHAPTER
10
PART
5
Valuing Early-Stage Ventures
315
Venture Capital Valuation Methods
361
Structuring Financing for the Growing Venture 405
CHAPTER
11
Professional Venture Capital 407
CHAPTER
CHAPTER
12
13
Other Financing Alternatives 431
Security Structures and Determining Enterprise Values
PART
6
Exit and Turnaround Strategies
457
493
CHAPTER
14
Harvesting the Business Venture Investment
CHAPTER
15
Financially Troubled Ventures: Turnaround Opportunities?
PART
7
495
529
Capstone Cases 563
CASE
1
Eco-Products, Inc.
CASE
2
Coral Systems, Inc.
CASE
3
Spatial Technology, Inc.
565
595
621
v
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Contents
Preface
PART
xvii
1
Background and Environment 1
CHAPTER 1
Introduction and Overview 3
1.1 The Entrepreneurial Process
5
1.2 Entrepreneurship Fundamentals
Who Is an Entrepreneur?
Basic Definitions
6
6
6
Entrepreneurial Traits or Characteristics
7
Opportunities Exist But Not Without Risks
1.3 Sources of Entrepreneurial Opportunities
Societal Changes
7
9
9
Demographic Changes
10
Technological Changes
Crises and “Bubbles”
11
12
1.4 Principles of Entrepreneurial Finance
14
Real, Human, and Financial Capital Must Be Rented from Owners (Principle #1)
Risk and Expected Reward Go Hand in Hand (Principle #2)
14
14
While Accounting Is the Language of Business, Cash Is the Currency
(Principle #3) 15
New Venture Financing Involves Search, Negotiation, and Privacy (Principle #4)
A Venture’s Financial Objective Is to Increase Value (Principle #5)
15
16
It Is Dangerous to Assume That People Act Against Their Own Self-Interests
(Principle #6) 17
Venture Character and Reputation Can Be Assets or Liabilities (Principle #7)
1.5 Role of Entrepreneurial Finance
1.6 The Successful Venture Life Cycle
Development Stage
Startup Stage
22
Survival Stage
22
20
21
Rapid-Growth Stage
22
Early-Maturity Stage
22
Life Cycle Stages and the Entrepreneurial Process
1.7 Financing Through the Venture Life Cycle
Seed Financing
18
19
23
23
24
vii
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viii
Contents
Startup Financing
25
First-Round Financing
26
Second-Round Financing
Mezzanine Financing
26
27
Liquidity-Stage Financing
Seasoned Financing
27
28
1.8 Life Cycle Approach for Teaching Entrepreneurial Finance
Summary
28
31
CHAPTER 2
From the Idea to the Business Plan 37
2.1 Process for Identifying Business Opportunities
39
2.2 To Be Successful, You Must Have a Sound Business Model
Component 1: The Plan Must Generate Revenues
Component 2: The Plan Must Make Profits
40
40
41
Component 3: The Plan Must Produce Free Cash Flows
42
2.3 Learn From the Best Practices of Successful Entrepreneurial Ventures
Best Marketing Practices
Best Financial Practices
42
43
43
Best Management Practices
44
Best Production or Operations Practices Are Also Important
2.4 Time-To-Market and Other Timing Implications
44
45
2.5 Initial “Litmus Test” for Evaluating the Business Feasibility of an Idea
2.6 Screening Venture Opportunities
46
48
An Interview with the Founder (Entrepreneur) and Management Team: Qualitative
Screening 49
Scoring a Prospective New Venture: Quantitative Screening
Industry/Market Considerations
56
Pricing/Profitability Considerations
Financial/Harvest Considerations
57
59
Management Team Considerations
Opportunity Screening Caveats
61
62
2.7 Key Elements of a Business Plan
63
Cover Page, Confidentiality Statement, and Table of Contents
Executive Summary
Business Description
65
Operations and Support
65
65
66
Financial Plans and Projections
Risks and Opportunities
67
Business Plan Appendix
68
Summary
63
65
Marketing Plan and Strategy
Management Team
51
66
69
Appendix A Applying the VOS Indicator™: An Example
75
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Contents
PART
ix
2
Organizing and Operating the Venture 79
CHAPTER 3
Organizing and Financing a New Venture 81
3.1 Progressing through the Venture Life Cycle
3.2 Forms of Business Organization
Proprietorships
84
85
General and Limited Partnerships
Corporations
82
87
90
Limited Liability Companies
92
3.3 Choosing the Form of Organization: Tax and Other Considerations
3.4 Intellectual Property
96
Protecting Valuable Intangible Assets
97
What Kinds of Intellectual Property Can Be Protected?
97
Other Methods for Protecting Intellectual Property Rights
3.5 Seed, Startup, and First-Round Financing Sources
Financial Bootstrapping
106
Business Angel Funding
108
First-Round Financing Opportunities
Summary
93
103
104
111
112
CHAPTER 4
Measuring Financial Performance 119
4.1 Obtaining and Recording the Resources Necessary to Start and Build a New
Venture 121
4.2 Business Assets, Liabilities, and Owners’ Equity
Balance Sheet Assets
123
Liabilities and Owners’ Equity
4.3 Sales, Expenses, and Profits
4.5 Statement of Cash Flows
125
126
4.4 Internal Operating Schedules
128
131
4.6 Operating Breakeven Analyses
Survival Breakeven
122
133
134
Identifying Breakeven Drivers in Revenue Projections
Summary
138
140
Appendix A NOPAT Breakeven: Revenues Needed to Cover Total Operating Costs
147
CHAPTER 5
Evaluating Financial Performance 151
5.1 Users of Financial Performance Measures by Life Cycle Stage
5.2 Using Financial Ratios
152
154
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x
Contents
5.3 Cash Burn Rates and Liquidity Ratios
156
Measuring Venture Cash Burn and Build Amounts and Rates
Beyond Burn: Traditional Measures of Liquidity
158
Interpreting Cash-Related and Liquidity-Related Trends
5.4 Conversion Period Ratios
162
Interpreting Changes in Conversion Times
164
166
Measuring Financial Leverage
166
Interpreting Changes in Financial Leverage
5.6 Profitability and Efficiency Ratios
169
169
Income Statement Measures of Profitability
Efficiency and Return Measures
169
171
Interpreting Changes in Profitability and Efficiency
5.7 Industry Comparable Ratio Analysis
PART
173
174
5.8 A Hitchhiker’s Guide to Financial Analysis
Summary
160
161
Measuring Conversion Times
5.5 Leverage Ratios
157
175
177
3
Planning for the Future 187
CHAPTER 6
Financial Planning: Short Term and Long Term 189
6.1 Financial Planning Throughout the Venture’s Life Cycle
6.2 Surviving in the Short Run
191
192
6.3 Short-Term Cash-Planning Tools
194
6.4 Projected Monthly Financial Statements
199
6.5 Cash Planning from a Projected Monthly Balance Sheet
6.6 Beyond Survival: Systematic Forecasting
Forecasting Sales for Seasoned Firms
201
202
203
Forecasting Sales for Early-Stage Ventures
205
6.7 Estimating Sustainable Sales Growth Rates
209
6.8 Estimating Additional Financing Needed to Support Growth
The Basic Additional Funds Needed Equation
Impact of Different Growth Rates on AFN
Estimating the AFN for Multiple Years
213
215
216
6.9 Percent-of-Sales Projected Financial Statements
Forecasting Sales
212
216
217
Projecting the Income Statement
Projecting the Balance Sheet
217
219
Forecasting the Statement of Cash Flows
220
Financing Cost Implications Associated with the Need for Additional Funds
Summary
222
223
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Contents
xi
CHAPTER 7
Types and Costs of Financial Capital 231
7.1 Implicit and Explicit Financial Capital Costs
7.2 Financial Markets
233
233
7.3 Determining the Cost of Debt Capital
235
Determinants of Market Interest Rates
236
Risk-Free Interest Rate
237
Default Risk Premium
238
Liquidity and Maturity Risk Premiums
A Word on Venture Debt Capital
7.4 What Is Investment Risk?
241
243
244
Measuring Risk as Dispersion Around an Average
Historical Return versus Risk Relationships
7.5 Estimating the Cost of Equity Capital
247
250
Cost of Equity Capital for Public Corporations
Cost of Equity Capital for Private Ventures
Sources and Costs of Venture Equity Capital
7.6 Weighted Average Cost of Capital
250
252
254
257
A Life Cycle–Based WACC Example
Summary
244
257
259
Appendix A Using WACC to Complete the Calibration of EVA
267
CHAPTER 8
Securities Law Considerations When Obtaining Venture Financing 269
8.1 Review of Sources of External Venture Financing
8.2 Overview of Federal and State Securities Laws
Securities Act of 1933
271
273
273
Securities Exchange Act of 1934
274
Investment Company Act of 1940
Investment Advisers Act of 1940
274
275
State Securities Regulations: “Blue-Sky” Laws
275
8.3 Process for Determining Whether Securities Must Be Registered
Offer and Sale Terms
What Is a Security?
276
276
277
8.4 Registration of Securities under the Securities Act of 1933
8.5 Security Exemptions from Registration under the 1933 Act
279
282
8.6 Transaction Exemptions from Registration under the 1933 Act
Private Offering Exemption
284
285
Accredited Investor Exemption
286
8.7 SEC’s Regulation D: Safe-Harbor Exemptions
287
Rule 504: Exemption for Limited Offerings and Sales of Securities Not Exceeding
$1 Million 287
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xii
Contents
Rule 505: Exemption for Limited Offers and Sales of Securities Not Exceeding $5
Million 289
Rule 506: Exemption for Limited Offers and Sales Without Regard to Dollar Amount
of Offering 290
8.8 Regulation A Security Exemption
Summary
291
292
Appendix A Schedule A
295
Appendix B Selected SEC Regulation D Materials
299
Appendix C Other Forms of Registration Exemptions and Breaks
PART
310
4
Creating and Recognizing Venture Value 313
CHAPTER 9
Valuing Early-Stage Ventures 315
9.1 What Is a Venture Worth?
Does the Past Matter?
317
Looking to the Future
317
316
Vested Interests in Value: Investor and Entrepreneur
318
9.2 Basic Mechanics of Valuation: Mixing Vision and Reality
Present Value Concept
319
319
If You’re Not Using Estimates, You’re Not Doing a Valuation
Divide and Conquer with Discounted Cash Flow
9.3 Required Versus Surplus Cash
321
322
325
9.4 Developing the Projected Financial Statements for a DCF Valuation
9.5 Just-in-Time Equity Valuation: Pseudo Dividends
9.6 Accounting versus Equity Valuation Cash Flow
Origins of Accounting Cash Flows
338
338
From Accounting to Equity Valuation Cash Flows
Summary
327
331
338
343
CHAPTER 10
Venture Capital Valuation Methods 361
10.1 Brief Review of Basic Cash Flow-Based Equity Valuations
10.2 Basic Venture Capital Valuation Method
Using Present Values
Using Future Values
367
368
10.3 Earnings Multipliers and Discounted Dividends
10.4 Adjusting VCSCs for Multiple Rounds
First Round
Second Round
363
364
368
370
371
371
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Contents
10.5 Adjusting VCSCs for Incentive Ownership
First Round
372
372
Second Round
373
Incentive Ownership Round
373
10.6 Adjusting VCSCs for Payments to Senior Security Holders
10.7 Introducing Scenarios to VCSCs
Utopian Approach
Mean Approach
Summary
PART
xiii
373
375
375
377
381
5
Structuring Financing for the Growing Venture 405
CHAPTER 11
Professional Venture Capital 407
11.1 Historical Characterization of Professional Venture Capital
11.2 Professional Venture Investing Cycle: Overview
11.3 Determining (Next) Fund Objectives and Policies
11.4 Organizing the New Fund
414
415
11.5 Soliciting Investments in the New Fund
418
11.6 Obtaining Commitments for a Series of Capital Calls
11.7 Conducting Due Diligence and Actively Investing
11.8 Arranging Harvest or Liquidation
419
419
427
11.9 Distributing Cash and Securities Proceeds
Summary
409
413
427
428
CHAPTER 12
Other Financing Alternatives 431
12.1 Facilitators, Consultants, and Intermediaries
12.2 Commercial and Venture Bank Lending
433
433
12.3 Understanding Why You May Not Get Debt Financing
12.4 Credit Cards
436
438
12.5 Small Business Administration Programs
439
Overview of What the SBA Does for Small Businesses
Selected SBA Loan and Operating Specifics
12.6 Other Government Financing Programs
12.7 Receivables Lending and Factoring
439
441
445
446
12.8 Debt, Debt Substitutes, and Direct Offerings Vendor Financing: Accounts Payable
and Trade Notes 448
Mortgage Lending
448
Traditional and Venture Leasing
Direct Public Offers
Summary
448
449
449
Appendix A Summary of Colorado Business Financial Assistance Options
453
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xiv
Contents
CHAPTER 13
Security Structures and Determining Enterprise Values 457
13.1 Common Stock or Common Equity
459
13.2 Preferred Stock or Preferred Equity
459
Selected Characteristics
Convertible Preferreds
460
461
Conversion Value Protection
462
Conversion Protection Clauses
463
Conversion Price Formula (CPF)
Market Price Formula (MPF)
13.3 Convertible Debt
464
464
466
13.4 Warrants and Options
467
13.5 Other Concerns about Security Design
472
13.6 Valuing Ventures with Complex Capital Structures: The Enterprise Method
Summary
PART
473
480
6
Exit and Turnaround Strategies 493
CHAPTER 14
Harvesting the Business Venture Investment 495
14.1 Venture Operating and Financial Decisions Revisited
14.2 Planning an Exit Strategy
498
14.3 Valuing the Equity or Valuing the Enterprise
Relative Valuation Methods
14.5 Outright Sale
501
503
504
Family Members
Managers
499
500
Dividing the Venture Valuation Pie
14.4 Systematic Liquidation
504
505
An Example
506
Employees
508
Outside Buyers
14.6 Going Public
509
511
Investment Banking
511
Some Additional Definitions
514
Other Costs in Issuing Securities
Post-IPO Trading
515
516
Contemplating and Preparing for the IPO Process
Summary
497
518
522
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Contents
xv
CHAPTER 15
Financially Troubled Ventures: Turnaround Opportunities? 529
15.1 Venture Operating and Financing Overview
15.2 The Troubled Venture and Financial Distress
Balance Sheet Insolvency
Cash Flow Insolvency
531
531
533
533
Temporary versus Permanent Cash Flow Problems
15.3 Resolving Financial Distress Situations
Operations Restructuring
Asset Restructuring
538
540
Financial Restructuring
543
15.4 Private Workouts and Liquidations
Private Workouts
535
536
544
544
Private Liquidations
545
Venture Example: Jeremy’s MicroBatch Ice Creams, Inc.
15.5 Federal Bankruptcy Law
Bankruptcy Reorganizations
546
Reasons for Legal Reorganizations
Legal Reorganization Process
Bankruptcy Liquidations
Summary
PART
545
546
547
549
552
556
7
Capstone Cases 563
CASE 1
Eco-Products, Inc. 565
CASE 2
Coral Systems, Inc. 595
CASE 3
Spatial Technology, Inc. 621
Glossary
Index
645
655
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Preface
T
he life of an entrepreneur is exciting and dynamic. The challenge of envisioning
a new product or service, infecting others with entrepreneurial zeal, and bringing
a product to market can be one of the great learning experiences in life. All ventures require financing—taking investors’ money today and expecting to return a significantly larger amount in the future. Typically the return comes from the venture’s public
offering, sale, or merger. In the interim, the venture must manage its financial resources,
communicate effectively with investors and partners, and create the harvest value expected by investors.
TEXTBOOK MOTIVATION
The purpose of the textbook is to introduce financial thinking, tools, and techniques
adapted to the realm of entrepreneurship. We believe that, while much of traditional financial analysis may not be ideally suited to the venture context, there is great value in
applying venture adaptations.
This entrepreneurial finance text introduces the theories, knowledge, and financial
tools an entrepreneur needs to start, build, and harvest a successful venture. Sound financial management practices are essential to a venture’s operation. The successful entrepreneur must know how and where to obtain the financing necessary to launch and develop
the venture. Eventually, that same successful entrepreneur must know how and when to
interact with financial institutions and regulatory agencies to take the venture to its potential and provide a return and liquidity for the venture’s investors.
THE LIFE CYCLE APPROACH
We incorporate a life cycle approach to the material in this text. Successful ventures
typically begin with an initial development stage where the entrepreneurial team generates ideas and assesses the associated business opportunities. Most entrepreneurs realize that a business plan can greatly improve the chance that an idea will become a
commercially viable product or service. Startup stage ventures focus on the formulation of a business model and plan. As marketing and selling products and services begins, survival stage ventures often refocus or restructure. Rapid growth stage ventures
increase their momentum, and begin to demonstrate value creation. Maturity stage
ventures typically look for ways to harvest the value created and provide a return to
their investors.
Each stage in the life cycle requires a specific understanding of the financial management tools and techniques, potential investors and their mindset, and the financial institutions supporting that venture stage. During the early stages of a venture’s
life, cash management tools and survival planning are the dominant forms of financial
analysis. Cash burn rates are very high and additional sources of financing are usually
limited, making it critical for the successful venture to project and accommodate necessary operating costs. The need to measure and adjust investment in working capital and
property, plant, and equipment is evident. The process of anticipating and
xvii
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xviii
Preface
accommodating costs and asset investments begins with the analysis of historical financial experience and then projects future financial positions using projected financial
statements or their proxies. Successful ventures emerging from their survival stages can
concentrate more on value creation and calibration. Consequently, our financial management emphases for this stage are valuation tools and techniques.
Equally important as sound financial management practices is the need for the entrepreneur to understand the types and sources of financial capital and the related
investment processes. During the development stage, seed financing usually comes
from the entrepreneur’s personal assets and possibly from family and friends. Business
angels and venture capitalists are important financing sources during the startup stage.
First-round financing from business operations, venture capitalists, suppliers, customers,
and commercial banks may be initiated during the survival stage. The rapid growth stage
involves second-round, mezzanine, and liquidity stage financing from business operations, suppliers, customers, commercial banks, and investment bankers. Once a venture
enters its maturity stage, seasoned financing replaces venture financing. Seasoned financing takes the form of cash flow from business operations, bank loans, and stocks and
bonds issued with the assistance of investment bankers or others. Our approach is to
introduce the types and sources of financial capital that become available as we progress
through a successful venture’s life cycle.
The successful entrepreneur must understand the legal environment regulating
financial relationships between the venture, investors, and financial institutions including venture capital funds and investment banks. We cover the basic securities laws
and regulatory agencies, particularly the Securities and Exchange Commission (SEC), relevant to the entrepreneur when considering how to obtain financial capital at each stage.
To summarize, we take a comprehensive three-pronged stage-sensitive approach to
entrepreneurial finance. Our coverage of entrepreneurship-adapted financial analysis
and relevant institutional details provides a relevant financial analysis base for the entrepreneur in each of the various stages as he or she develops the idea, brings it to market,
grows the venture’s value, and ultimately provides an exit for venture investors. We identify and explain the types and sources of financing available during the various stages
and introduce the relevant legal and regulatory environment the entrepreneur must consider when seeking financing throughout the venture’s life cycle.
DISTINCTIVE FEATURES
This text considers a successful firm as it progresses through various maturity stages.
Specific examples of stage-relevant skills and techniques we introduce include:
•
•
•
•
Brainstorming and Screening: Chapter 2 (From the Idea to the Business Plan)
introduces qualitative and quantitative venture screening devices. Chapter 3’s
(Organizing and Financing a New Venture) treatment of intellectual property
issues demonstrates important issues and concepts for the earliest stage ventures.
Raising External Funds: Chapter 8’s (Securities Law Considerations When
Obtaining Venture Financing) treatment of securities law introduces readers to
the restrictions and warnings for the growing venture seeking external financing.
Venture Diagnostics and Valuation: Chapter 9 (Valuing Early-Stage Ventures)
presents our versions of traditional valuation techniques important to internal and
external perceptions of a venture’s financial health. While the material is traditional,
our treatment provides a unifying approach to projecting financial statements,
extracting pseudo-dividends, and assessing a venture’s value.
Venture Capital Valuation Methods: Chapter 10 (Venture Capital Valuation
Methods) introduces representative multi-stage venture capital valuation methods
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Preface
•
•
•
xix
and interprets them relative to more traditional procedures. It provides a unified
example of traditional pre-money and post-money valuations and the shortcuts
employed by many venture capitalists.
Professional VCs: Chapter 11 (Professional Venture Capital) explores the historical
development of venture capital and describes the professional venture investing cycle
from determining the next fund objectives and policies to distributing cash and
securities proceeds to investors.
Harvest: Chapter 14 (Harvesting the Business Venture Investment) considers a wide
range of venture harvest strategies including private sales (to outsiders, insiders, and
family), transfers of assets, buyouts, and initial public offerings.
Turnaround Opportunities: Chapter 15 (Financially Troubled Ventures: Turnaround
Opportunities?) introduces important aspects of financial distress and alternative
restructuring approaches (operations, asset, and financial) to rescue a struggling venture.
INTENDED AUDIENCE AND USE
The material contained in this text has been used successfully at the upper division
(junior/senior) undergraduate, MBA, and executive MBA levels. For MBAs, the course
can easily be conducted in two ways. In the first, what we term the life cycle approach,
we recommend the addition of illustrative cases, each at different life cycle stages. Recently, entrepreneurial finance cases have been available individually from the usual providers and in collected form in entrepreneurial case books. The second, or what we term
the venture capital approach, emphasizes the money management aspects of financing
entrepreneurial ventures. For this approach, we recommend supplementing the text
treatments with venture capital cases (available individually or in collected case books)
and journal articles covering private equity (venture capital) and initial public offerings
(investment banking). For an abbreviated mini-semester course or compressed executive
MBA, we recommend concentrating on the text and using our capstone cases as focal
points for integrating the venture financing perspective.
We have also used this text for semester-long upper division (junior/senior-level) undergraduate courses involving finance and non-finance business majors. Most academic business programs require students to take basic background courses in both accounting and
finance prior to upper division courses such as entrepreneurial finance. Chapters 9, 10,
and 13 present a rigorous and conceptually advanced approach to financial valuation. Our
experience is that these chapters provide the greatest intellectual challenge and require relatively sophisticated spreadsheet skills. The fourth edition of this textbook has been written
to support two different approaches to the undergraduate entrepreneurial finance course.
The more rigorous approach challenges undergraduate students by covering all 15 chapters
including all valuation materials and has a decision-making focus. An alternative approach
is to teach a more descriptive or conceptual course. For those preferring this latter approach,
we recommend that Part 4 (Chapters 9 and 10) and Chapter 13 from Part 5 be omitted or
covered in a descriptive (no modeling or calculations) manner. For application, while the
included capstone cases synthesize a great deal of the text’s material, some instructors find
it useful to have students prepare short cases in lieu of, or prior to, these capstones.
Regarding the accounting and basic finance background material in Chapters 4 and 5,
we provide it for student and instructor convenience when the material has not been
covered in prerequisite courses or in instances when a review of the materials is warranted. The remainder of the text can be used without explicit coverage of this review
material. Additionally, for some adopters, it may be advantageous to alter the sequencing
and coverage of the securities law and investment banking material, depending on student backgrounds and other course offerings.
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xx
Preface
ADDITIONS AND CHANGES IN THE FOURTH EDITION
Overall changes to content and organization include:
•
•
•
•
•
•
•
•
•
•
Addition of a new feature in each chapter: a “From the Headlines” story relating to
an entrepreneurial venture. A discussion question related to the “From the Headlines” feature is provided in the end of chapter material.
Addition of pedagogical guidance: each exercise/problem at the end of each chapter
is preceded by a brief description in italics of the content or focus of the exercise or
problem.
Chapter 1 (Introduction and Overview) was substantially rewritten to reflect the
current focus on environmentally friendly products and “clean tech” and “clean
energy” potential applications and entrepreneurial venture opportunities was added.
The appendix on “Internet Concepts and Developments” was removed. Discussion
of the 2007–2009 financial crisis and resulting entrepreneurial venture
opportunities was added.
Chapter 3 (Organizing and Financing a New Venture) includes updated personal
and corporate income tax information and reorganized problems to follow chapter
topics.
Chapter 5 (Evaluating Financial Performance) was edited to improve the clarity of
the cash burn discussion. We added new financial ratio problems and restructured
the mini-case.
Chapter 6 (Financial Planning: Short Term and Long Term) includes addition of
problem materials on sustainable sales growth rates and additional funds needed.
The Pharma Biotech mini-case was restructured.
Chapter 9 (Valuing Early-Stage Ventures) was reorganized consolidating the multiple approaches to free cash flow valuation methods. Some of the materials were
moved into a Learning Supplement.
Chapter 13 (Security Structures and Determining Enterprise Values) includes a
substantially rewritten section on “Valuing Ventures with Complex Capital Structures: The Enterprise Method” with the focus on presenting one method consistent
with Chapter 9. An alternative enterprise valuation method is now presented as
Learning Supplement 13A.
Chapter 14 (Harvesting the Business Venture Investment) includes new material on
“employee stock ownership plans (ESOPs).” Material in the “Post-IPO Trading”
section was updated to reflect current NYSE and NASDAQ listing requirements
data.
New Capstone Case: Eco-Products, Inc. We added a new case for a company that
produces and sells environmentally sound food service products from renewable resources. The related early-stage financing decisions involve: (a) raising funds
through a private placement memorandum, and (b) a proposed private placement
with an investment firm utilizing a term sheet. Excerpts from the private placement
memorandum and the term sheet are provided for student review and analysis.
SUPPLEMENTS
Instructor’s Manual with Test Bank
Written by the text authors, the Instructor’s Manual includes short answers to endof-chapter questions and answers to end-of-chapter problems. The Test Bank includes
true/false and multiple choice questions, as well as short test problems. Both Instructor’s
Manual and Test Bank are available on the text Web site for instructors only.
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Preface
xxi
PowerPoint Lecture Slides
Created by the text authors, the PowerPoint slides present a point-by-point lecture outline, including graphics and equations, for instructors to use in the classroom. They are
available on the text Web site for instructors only.
Excel Solutions
Excel Solutions to end-of-chapter problems requiring Excel are provided for instructors
on the text Web site.
Text Web Site
The text Web site at www.cengagebrain.com provides access to these supplements.
Acknowledgments
During the several years we spent developing and delivering this material, we benefited
from interactions with colleagues, students, entrepreneurs, and venture capitalists. We
thank the numerous sections of students who became the sounding board for our presentation of this material. We also thank the members of the Venture Capital Association of Colorado who opened their professional lives and venture capital conferences to
our students. Additionally, we have benefited from detailed valuable comments and input by Craig Wright and Michael Meresman. Clinton Talmo and Robert Donchez contributed to the preparation of the Instructor’s Manual.
We recognize the moral support of the Deming Center for Entrepreneurship (Bob
Deming, and directors Dale Meyer, Denis Nock, Kathy Simon, Steve Lawrence and
Paul Jerde). We thank the Coleman Foundation for research support for the Coral Systems, Inc. and Spatial Technology, Inc. cases and the Educational Legacy Fund for research support for the Eco-Products, Inc. case.
We recognize the valuable contributions of our editorial staff at Cengage Learning,
including Michael Mercier, our original acquisitions editor who believed in our book enough to publish it; Mike Reynolds, our current Cengage Learning executive editor, and
Adele Scholtz our developmental editor. Also, we’d like to thank our production manager, Tamborah Moore and our marketing manager, Nate Anderson. We also thank
Martha Leach for research assistance behind the “From the Headlines” stories and for
proofreading a complete version of this fourth edition. We thank Andre Gygax, Hardjo
Koerniadi, and Cody Engle who provided several important corrections to previous
materials.
For their patience and insights offered during the process, we thank our colleagues
who reviewed materials for this fourth edition or earlier editions of the text:
Brian Adams, University of Portland
MJ Alhabeeb, University of Massachusetts
Olufunmilayo Arewa, Northwestern University
David Choi, Loyola Marymount University
Susan Coleman, University of Hartford
David Culpepper, Millsaps College
John Farlin, Ohio Dominican
David Hartman, Central Connecticut State University
William C. Hudson, St. Cloud State University
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xxii
Preface
Narayanan Jayaraman, Georgia Tech
Jeffrey June, Miami University
Miranda Lam, Salem State College
Michael S. Long, Rutgers University
Michael Owens, University of Tennessee Chattanooga
Robert Patterson, Westminster College
Charles B. Ruscher, University of Arizona
Steven R. Scheff, Florida Gulf Coast University
Gregory Stoller, Boston College
Srinivasan Sundaram, Ball State University
Michael Williams, University of Denver
Finally, to our families for their patience through four editions, we offer our sincere
thanks.
J. Chris Leach
Ronald W. Melicher
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© Marie C. Fields/Shutterstock.com
About the Authors
J. Chris Leach is Professor and Chair of the Finance Division and the Robert H. and
Beverly A. Deming Professor in Entrepreneurship at the Leeds School of Business, University of Colorado at Boulder. He received a finance Ph.D. from Cornell University, began
his teaching career at the Wharton School and has been a visiting professor at Carnegie
Mellon, the Indian School of Business, and the Stockholm Institute for Financial Research
(at the Stockholm School of Economics). His teaching experience includes courses for
undergraduates, MBAs, Ph.D. students, and executives. He has been recognized as Graduate Professor of the Year and has received an award for MBA Teaching Excellence. His
research on a variety of topics has been published in The Review of Financial Studies, Journal of Financial and Quantitative Analysis, Journal of Business, and Journal of Money,
Credit and Banking, among other journals.
Chris’s business background includes various startups dating back to his early teens in
the 1970s. During his transition to the University of Colorado, he was the chairman of a
New Mexico startup and later, as an investor and advisor, participated in a late 1990s Silicon Valley startup that subsequently merged into a public company. His consulting activities include business and strategic planning advising, valuation, and deal structure for early
stage and small businesses. He is a faculty advisor for the Deming Center Venture Fund
and a member of the Deming Center Board of Directors. MBA teams Chris has sponsored
have qualified for six international championships of the Venture Capital Investment
Competition.
Ronald W. Melicher is Professor of Finance in the Leeds School of Business at the University of Colorado at Boulder. He earned his undergraduate, MBA, and doctoral degrees
from Washington University in St. Louis, Missouri. While at the University of Colorado,
he has received several distinguished teaching awards and was designated as a universitywide President’s Teaching Scholar. He also has held the William H. Baugh Distinguished
Scholar faculty position, served three multi-year terms as Chair of the Finance Division,
served as the Faculty Director of the Boulder Campus MBA Program, and was the
Academic Chair of the three-campus Executive MBA Programs.
Ron has taught entrepreneurial finance at both the MBA and undergraduate levels. He
also teaches corporate finance and financial strategy in the MBA and Executive MBA programs and investment banking to undergraduate students. While on sabbatical leave from
the University of Colorado, Ron has taught at the INSEAD Graduate School of Business in
Fontainebleau, France and at the University of Zurich in Zurich, Switzerland. He has delivered numerous university-offered executive education non-credit courses and has taught
in-house finance education materials for IBM and other firms. He has given expert witness
testimony on cost of capital in regulatory proceedings and has provided consulting expertise in the areas of financial management and firm valuation.
Ron’s research interests focus on mergers and acquisitions, corporate restructurings,
and the financing and valuation of early-stage firms. His previous research has been published in major finance journals including the Journal of Finance, Journal of Financial and
Quantitative Analysis, and Financial Management. He is the co-author of Introduction
to Finance: Markets, Investments, and Financial Management, Fourteenth Edition (John
Wiley & Sons, 2011).
xxiii
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PART
Background and
Environment
1
Chapter 1
Introduction and Overview
Chapter 2
© Marie C. Fields/Shutterstock.com
From the Idea to the Business Plan
1
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
CHAPTER
Introduction
and Overview
1
FIRST THOUGHTS
Only those individuals with entrepreneurial experience can say, “Been there, done that!”
With aspiring entrepreneurs in mind, we start at the beginning and consider how entrepreneurial finance relates to the other aspects and challenges of launching a new venture. Our goal is to equip you with the terms, tools, and techniques that can help turn a
business idea into a successful venture.
LOOKING AHEAD
Chapter 2 focuses on the transformation of an idea into a business opportunity and the
more formal representation of that opportunity as a business plan. Most successful ideas
are grounded in sound business models. We present qualitative and quantitative screening exercises that can help determine an idea’s commercial viability. We provide a brief
discussion of a business plan’s key elements.
CHAPTER LEARNING OBJECTIVES
This chapter presents an overview of entrepreneurial finance. We hope to convey the
potential benefit of embracing standard entrepreneurial finance methods and techniques.
We consider an entrepreneur’s operating and financial decisions at each stage, as
the venture progresses from idea to harvest. After completing this chapter, you will be
able to:
1.
2.
3.
4.
5.
6.
7.
8.
Characterize the entrepreneurial process.
Describe entrepreneurship and some characteristics of entrepreneurs.
Indicate three megatrends providing waves of entrepreneurial opportunities.
List and describe the seven principles of entrepreneurial finance.
Discuss entrepreneurial finance and the role of the financial manager.
Describe the various stages of a successful venture’s life cycle.
Identify, by life cycle stage, the relevant types of financing and investors.
Understand the life cycle approach used in this book.
3
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
4
Part 1: Background and Environment
From the Headlines
Small Wind Gets a Gust from CLEANtricity Power
According to a recent poll, 89% of U.S. voters, including 84% of Republicans, 88% of
Independents, and 93% of Democrats, believe that increasing the amount of energy
their nation gets from wind is a good idea.1
While these voters and their parties find
plenty of issues on which they vehemently
disagree, there is little doubt that the United
States and the world will continue to increase its efforts to harvest energy from
the wind. In 2008, 42% of all new generating
capacity in the United States came from
wind, up from only 2% in 2004.2
Much of the public’s attention has been
focused on large-scale wind farming, complete with landscape photos of rows of towering wind turbines sporting massive
propellers. Less in the limelight, but every
bit as much in the game, are ventures targeting small-scale wind turbine electricity generation. Like their cousins in other renewable
energy categories, including those working
with micro biofuel and solar energy production, small-scale wind energy generation
ventures are contributing to the debate on
viable paths forward in the renewable energy markets.
CLEANtricity Power, located in Broomfield, Colorado, is one of the new players
in the “small wind market.” The American
Wind Energy Association characterizes that
Small Business
Administration (SBA)
............................
established by the federal
government to provide
financial assistance to small
businesses
market by the target customers and the rated
capacity of the generating technology:
Small wind turbines are electric generators that utilize wind energy to produce clean, emissions-free power for
individual homes, farms, and small
businesses. With this simple and increasingly popular technology, individuals can generate their own power
and cut their energy bills while helping
to protect the environment. The United
States leads the world in the production of small wind turbines, which are
defined as having rated capacities of
100 kilowatts and less, and the market
is expected to continue strong growth
through the next decade.3
CLEANtricity’s intent is to manufacture
small-scale wind turbines that “enable individuals, businesses, and communities to generate reliable, affordable clean energy where
they use it.” Their current product offering,
known as the SHAPEshifter, is a vertical-axis
self-adjusting wind turbine capable of electricity generation at lower wind speeds than the
usual 30 miles per hour targeted by competing
technology. It accomplishes this versatility by
morphing into a more efficient shape depending on the speed of the wind. Co-founder and
chief executive officer Daniel Sullivan sum-
marizes this capability as “it’s large in low
winds and small in high winds…the blades
move naturally to their optimum position.”4
Given that North American wind speeds at
60 feet above ground only average 7.3 miles
per hour, SHAPEshifter’s functionality at lower
speeds and its ability to adapt to higher
speeds offer a potentially important advantage
in the small-scale wind generation market.
CLEANtricity is a self-funded 2009 startup
and was one of twelve semifinalists at the 2009
Rocky Mountain Region Clean Tech Open. At
the time we met with them with prototype,
provisional patent, and field tests in hand,
they were seeking $2 million in external
financing.
..................
1
2
3
4
American Wind Energy Association press release,
April 22, 2010, citing poll conducted by Neil Newhouse of Public Opinion Strategies and Anna Bennett of Bennett, Petts & Normington; press release
available at http://www.awea.org/newsroom/
releases/04-22-10_Poll_Shows_Wind_Works_for_
Americans.html visited on 4/25/2010.
American Wind Energy Association, “Wind, A
Leading Source of New Electricity Generation,”
http://www.awea.org/pubs/documents/Outlook_
2009.pdf., visited on 4/25/2010.
http://www.awea.org/smallwind/visitedon4/25/2010.
Coloradobiz, December 2009, Tech Startup of the
Month, pg. 58. This article is also available at
http://www.cobizmag.com/articles/tech-startup1/.
I
t is estimated that more than one million new businesses are started in the United
States each year. The Office of Advocacy of the United States Small Business
Administration (SBA) documents that “employer firm births” have exceeded
600,000 annually in recent years.1 Reasonable estimates place non-employer (e.g., single
person or small family) businesses started each year at a similar number. In addition to
these formally organized startups, countless commercial ideas are entertained and
abandoned without the benefit of a formal organization. The incredible magnitude of
potential entrepreneurial opportunities is a clear reflection of the commercial energy
fostered by a market economy. We believe that the time spent on this book’s treatment
of financial tools and techniques may be one of the more important investments you
make.
..............................
1 The Office of Advocacy of the Small Business Administration (SBA) was created in 1976 by Congress to be an independent voice for small business within the federal government. Small business statistics are available at http://
www.sba.gov/advo/research/dyn_b_d8906.pdf.
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Chapter 1: Introduction and Overview
5
SECTION 1.1
THE ENTREPRENEURIAL PROCESS
entrepreneurial
process
............................
developing opportunities,
gathering resources, and
managing and building
operations with the goal
of creating value
FIGURE 1.1
The entrepreneurial process comprises: developing opportunities, gathering resources,
and managing and building operations, all with the goal of creating value. Figure 1.1
provides a graphical depiction of this process. Many entrepreneurship students have formulated ideas for possible new products and services. However, prior to committing significant time and resources to launching a new venture, it can really pay to take the time
and effort to examine the feasibility of an idea, screen it as a possible venture opportunity, analyze the related competitive environment, develop a sound business model, and
prepare a convincing business plan.
The second aspect of a successful entrepreneurial process involves gathering the physical assets, intellectual property, human resources, and financial capital necessary to
move from opportunity to entrepreneurial venture. The venture should organize formally
and legally, the process of which also provides an opportunity for founders to build consensus for the new venture’s boundaries of authority and basic ethical framework. Every
startup needs “seed” financing and must have a strategy for acquiring it.
The third piece of the entrepreneurial process is managing and building the venture’s
operations. An effective business model must generate revenues to cover operating costs
in the foreseeable future. Eventually, a growing venture will also need to provide enough
cash flow to cover planned expansion and reinvestment. Additional financing rounds,
possibly including those available through public securities offerings, may be necessary
for growth in later years.
Figure 1.1 depicts an intersection of all three components—creating value. Each of the
components contributes to the overall value. As a reminder of the wider context, we
place the components and their intersection in the context of the venture’s economic,
legal, and social environment.
THE ENTREPRENEURIAL PROCESS
Economic, Legal, and Social Environment
Developing
Opportunities
Creating
Value
Managing and
Building
Operations
Gathering
Resources
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6
Part 1: Background and Environment
CONCEPT CHECK
Q What are the components of the entrepreneurial process?
SECTION 1.2
ENTREPRENEURSHIP FUNDAMENTALS
Successful entrepreneurs recognize and develop viable business opportunities, have confidence in the market potential for their new products and services, and are committed
to “running the race.” They keep success in sight even when others may have difficulty
focusing.
Who Is an Entrepreneur?
After working for a large corporation for nearly five years, you are considering launching
a Web-based business. Product development and testing require financing that exceeds
your limited personal resources. How much external financing do you need to make a
credible attempt with the new venture? How much of the venture’s ownership will you
have to surrender to attract this initial financing?
A friend of yours, who graduated from college three years ago, started a new business
on the conviction that pumpkin stencils and special carving knives could foster an unprecedented commercial exploration of the market for Halloween crafts. Her firm has
experienced phenomenal growth and is seeking financing for this season’s inventory
stockpiling. Do her options differ from yours? Do the possible investors for your startup
and her later-stage venture move in the same circles?
Your neighbor is the chief executive officer (CEO) of a large firm founded twenty years
ago. He has accumulated enormous paper wealth and, before retirement, wishes to diversify
his investments. How do your neighbor’s investment goals and your financial needs relate to
one another? Is your neighbor a reasonable prospect for startup funding, or is he more
likely to spend the money he has allocated for earlier-stage investing on his own idea for a
new product? Does he see himself as an entrepreneur or as one who wants to enable and
profit from other entrepreneurs?
Who will succeed? Who will fail? Who is an entrepreneur? Your pumpkin-carving
friend? Your CEO neighbor? You? All of you or none of you? We offer no infallible formula
or process for entrepreneurial success. None exists. We cannot tell you if you should drop a
Fortune 500 career track and take up drinking from the entrepreneurial fire hose. We have
no blueprint for the ideal entrepreneur and no screening device to test for the entrepreneurial gene. Even if we had such a test, rest assured that for many who test positive, the news
might not be welcome, particularly to friends and family. The ups and downs of the entrepreneurial lifestyle are difficult for those supporting the entrepreneur financially and emotionally. Nonetheless, we believe that the tools and techniques we introduce can help
entrepreneurs and others anticipate venture challenges, navigate through shortfalls, and
achieve important milestones. Fortunately for the entrepreneur, employees, backers, and
their families, these tools and techniques can help smooth out an inevitably bumpy ride.
Basic Definitions
While the academic definition of “entrepreneurship” has evolved, it is useful to formalize
our context for the term. Jeffry Timmons and Stephen Spinelli suggest that “entrepreneurship is a way of thinking, reasoning, and acting that is opportunity obsessed,
holistic in approach, and leadership balanced for the purpose of value creation and
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Chapter 1: Introduction and Overview
entrepreneurship
............................
process of changing ideas
into commercial
opportunities and creating
value
CONCEPT CHECK
7
capture.”2 We adopt a somewhat shorter definition: Entrepreneurship is the process of
changing ideas into commercial opportunities and creating value. An entrepreneur is an
individual who thinks, reasons, and acts to convert ideas into commercial opportunities
and to create value. Whether entrepreneurial efforts succeed or fail, an entrepreneur’s
mission is to find economic opportunities, convert them into valuable products and services, and have their worth recognized in the marketplace.
Q What is the meaning of entrepreneurship?
Q Who is an entrepreneur?
entrepreneur
............................
Entrepreneurial Traits or Characteristics
individual who thinks,
reasons, and acts to convert
ideas into commercial
opportunities and to create
value
While we want to avoid most generalizations about entrepreneurial traits or characteristics, there are three we consider important. First, successful entrepreneurs recognize and
seize commercial opportunities, frequently before others even have an inkling of their
potential. Mark Twain once said, “I was seldom able to see an opportunity, until it
ceased to be one.” Second, successful entrepreneurs tend to be doggedly optimistic. The
glass is never “half empty” and usually not even “half full.” It is “full,” and they are ready
to call for more glasses. Third, successful entrepreneurs are not consumed entirely with
the present. Their optimism is conditional. They know that certain events need to take
place for this optimism to be justified. They do not treat venture planning as the enemy.
Seeing a (conditionally) bright future, successful entrepreneurs plan a way to get there
and begin to construct paths to obtain the required physical, financial, and human
resources.
While there are caricatures, there is no prototypical entrepreneur. Many authors have
tried to identify specific characteristics of successful entrepreneurs, but accurate generalizations have eluded them. There are numerous myths about entrepreneurs.3 One hears
that “entrepreneurs are born, not made.” Yet many successful entrepreneurs have been,
or will be, failing entrepreneurs if observed at different times in their lives. While identifying the fear of failure as a personal motivation propelling them forward, successful entrepreneurs are not paralyzed by this fear. If you see venture bumps as opportunities
rather than obstacles, perhaps the entrepreneurial lifestyle is right for you.
CONCEPT CHECK
Q What are some general traits or characteristics of entrepreneurs?
Opportunities Exist But Not Without Risks
If you feel the entrepreneurship bug biting, you are not alone. Remember, the annual number of new U.S. business formations runs in the millions. Small and growing enterprises
are critical to the U.S. economy; small firms provide 60 to 80 percent of net new jobs.4
Firms with fewer than 500 employees represent more than 99 percent of all employers
and employ over half of the private workforce. They are responsible for about half of the
private gross domestic product. During the past century, entrepreneurial firms’ innovations
..............................
2 Jeffry A. Timmons and Stephen Spinelli, New Venture Creation, 8th ed. (New York: McGraw-Hill/Irwin, 2009), p. 101.
3 Timmons and Spinelli address seventeen myths and realities about entrepreneurs and summarize prior efforts to identify characteristics of successful entrepreneurs. Ibid., pp. 59–60.
4 Small Business Economic Indicators (Washington, DC: U.S. Small Business Administration, Office of Advocacy, 2004).
An electronic version of the study including tables is available at http://sba.gov/advo/press/04-26.html.
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8
Part 1: Background and Environment
included personal computers, heart pacemakers, optical scanners, soft contact lenses, and
double-knit fabric. Entrepreneurial firms have long been major players in high-technology
industries, where small businesses account for over one-fourth of all jobs and over one-half
of U.S. innovations and new technologies. Small high-technology firms are responsible for
twice as many product innovations per employee, and obtain more patents per sales dollar,
than large high-technology firms. One government study suggests that some of the fastest
growing opportunities for small businesses are in the restaurant industry, medical and dental laboratories, residential care industries (housing for the elderly, group homes, etc.),
credit reporting, child daycare services, and equipment leasing.5
As much as we would like to encourage your entrepreneurial inclinations, it would be
irresponsible for us to imply that starting and successfully operating a business is easy.
As a basic financial principle, risk and return go together—the expectation of higher returns is accompanied by higher risks. According to the SBA’s Office of Advocacy, for the
years 2005 to 2007 employer firm births were estimated to be 659,093 per year. For the
same period, employer firm terminations averaged 578,793 annually. In 2008, however,
the estimated number of small business starts was below trend at 627,200, while the estimated number of closures was above trend at 595,600. Although bankruptcies averaged
only 29,073 per year in 2005 to 2007, they rose to 43,456 in 2008.6
Phillips and Kirchhoff, using Dun & Bradstreet data, found that 76 percent of new
firms were still in existence after two years of operation. Forty-seven percent of new
firms survived four years, and 38 percent were still operating after six years.7 In a more
recent study of the U.S. Census Bureau’s Business Information Tracking Series, Brian
Headd found similar results. Sixty-six percent of new employers survived two years,
50 percent were still in existence after four years, and 40 percent survived at least six
years. Headd also studied the U.S. Census Bureau’s Characteristics of Business Owners
database, which surveyed owners of closed firms on whether the owners felt their firms
were successful or unsuccessful at the time of closure. The evidence suggests that about
one-third of closed businesses were successful at closure. Thus, instead of closing due to
bankruptcy, many owners may have exited their businesses by retiring or selling.8
Nearly half of business failures are due to economic factors such as inadequate sales,
insufficient profits, or industry weakness. Of the remainder, almost 40 percent cite financial causes, such as excessive debt and insufficient financial capital. Other reasons include
insufficient managerial experience, business conflicts, family problems, fraud, and
disasters.9
Although the risks associated with starting a new entrepreneurial venture are large,
there is always room for one more success. Successful entrepreneurs are able to anticipate and overcome the business risks that cause others to fail. While hard work and a
little luck will help, an entrepreneur must be able to finance and manage the venture.
Commercial vision, an unrelenting drive to succeed, the ability to build and engage a
management team, a grasp of the risks involved, and a willingness to plan for the future
are some of the ingredients for success.
..............................
5 “Small Business Answer Card” and “The Facts about Small Business” (Washington, DC: U.S. Small Business
Administration, Office of Advocacy, 2000).
6 The Small Business Economy, http://www.sba.gov/advo/research/sb_econ2009.pdf.
7 B. Phillips and B.A. Kirchhoff, “Formation, Growth and Survival: Small Firm Dynamics in the U.S. Economy,” Small
Business Economics 1 (1989): pp. 65–74.
8 Brian Headd, “Redefining Business Success: Distinguishing Between Closure and Failure,” Small Business Economics
21 (2003): pp. 51–61.
9 “Small Business Answer Card” and “The Facts About Small Business.”
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Chapter 1: Introduction and Overview
CONCEPT CHECK
9
Q What percentage of new businesses survive four years of operation?
Q What are some of the major reasons why small businesses fail?
SECTION 1.3
SOURCES OF ENTREPRENEURIAL
OPPORTUNITIES
entrepreneurial
opportunities
............................
ideas with potential to create
value through different or
new, repackaged, or
repositioned products,
markets, processes,
or services
Entrepreneurs are the primary engine of commercial change in the global economy.
Entrepreneurial opportunities are ideas that have the potential to create value through
new, repackaged, or repositioned products, markets, processes, or services. One study of
Inc. magazine’s 500 high-growth firms suggests that about 12 percent of founders feel their
firms’ successes are due to extraordinary ideas, whereas the remaining 88 percent feel their
firms’ successes are due to exceptional execution of ordinary ideas.10 In a separate survey,
Amar Bhide found that Inc. 500 founders often make use of existing ideas originating in
their prior work experiences. Only 6 percent of his responding founders indicate that “no
substitutes were available” for their products or services. In contrast, 58 percent say they
succeeded even though competitors offer “identical or close substitutes.”11
Megatrends are large societal, demographic, or technological trends or changes that
are slow in forming but, once in place, continue for many years. In contrast, fads are
not predictable, have short lives, and do not involve macro changes. Of course, there
are many degrees between fads and megatrends that provide entrepreneurs with business
opportunities. However, while entrepreneurial opportunities can come from an almost
unlimited number of sources, we give special focus to the following three megatrend
categories:
Q
Q
Q
Q
Societal trends or changes
Demographic trends or changes
Technological trends or changes
Crises and “bubbles”
Societal Changes
Many entrepreneurial endeavors are commercial reflections of broader societal changes.
In 1982, John Naisbitt identified several major or megatrends shaping U.S. society and
the world.12 Naisbitt recognized that the U.S. economy, by the early 1980s, centered on
the creation and distribution of information. He argued that successful new technologies
would center on the human response to information. Many of the commercial opportunities in the past two decades have capitalized on information creation and organization
and its central role in human decision support.
..............................
10 J. Case, “The Origins of Entrepreneurship,” Inc., June 1989, p. 51.
11 Amar V. Bhide, The Origin and Evolution of New Businesses (New York: Oxford University Press, 2000).
12 John Naisbitt, Megatrends (New York: Warner Books, 1982). Although only two are presented here, Naisbitt identified
six additional megatrends. For a follow-up look at the megatrends shaping our society, see John Naisbitt and Patricia
Aburdene, Megatrends 2000 (New York: Morrow, 1990). In a 2007 article in Entrepreneur magazine, five forces that
shaped the face of entrepreneurship over the past three decades were identified as technology (the computer), the
Internet (a network to link computers), globalization (everyone can sell worldwide), baby boomers (question-authority
attitudes), and individualism (corporate restructurings forced individuals to look out for themselves). See Carol Tice,
“Change Agents,” Entrepreneur (May 2007), pp. 65–67.
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10
Part 1: Background and Environment
Naisbitt also recognized that the United States was increasingly affected by a global
economy and that Americans were rekindling the entrepreneurial spirit. It is now clear
that almost all businesses face international competition and that the pace of entrepreneurial innovation is increasing throughout the world. To succeed in such an environment requires an understanding of current megatrends and the anticipation of new
ones. While many possible trends are candidates for spawning entrepreneurial innovation, two that will undoubtedly influence future commercial opportunities are the
demographic shifts associated with the baby boom generation and our increasingly
information-oriented society.
Social, economic, and legal changes may occur within pervasive trends. Social changes
are reflected in important changes in preferences about clothing styles, food (e.g., glutenfree diets), travel and leisure, housing, and so forth. An anticipation of social change is
the genesis of many entrepreneurial opportunities as innovators position themselves to
satisfy the demand for the related new products and services. Economic shifts—the rise
of two-career families, higher disposable incomes, changing savings patterns—also suggest entrepreneurial opportunities. Changes in our legal environment can introduce important economic opportunities by eliminating existing barriers to entry. For example,
deregulation in the banking, transportation, and telecommunications industries has allowed entrepreneurs to provide cost-efficient, demand-driven alternatives.
CONCEPT CHECK
Q What are megatrends, and how do they introduce new commercial opportunities?
Demographic Changes
One major demographic trend continuing to shape the U.S. economy is the aging of the
so-called “baby boom generation.” In 1993, Harry Dent documented major generation
waves in the United States during the twentieth century.13 By far, the most important generation wave is the baby boom. After World War II, from 1946 to 1964, an unprecedented
number of babies, approximately 79 million, were born in the United States. As this generation has aged, it has repeatedly stressed the U.S. infrastructure. In the 1950s and 1960s,
it overloaded public school systems from kindergarten through high school. By the 1970s
and early 1980s, a period sometimes referred to as their innovation wave, boomers were
heavily involved in developing, innovating, and adopting new technologies.
Dent estimates that the boomers’ spending wave started in the early 1990s and peaked
in the late 1990s and the first part of the twenty-first century. The tremendous expansion
in the stock and bond markets during the 1980s and 1990s was, in part, due to the these
anticipated innovation and spending waves. Dent projects that the organization, or
power, wave, where boomers dominate top managerial positions and possess the accumulated wealth to influence corporate America, will peak sometime in the 2020s.
For the entrepreneurially inclined, the good news is that the boomers continue to
spend at record levels; “consumer confidence” is a key ingredient to America’s continued
prosperity and expansion. Financing continues to be available for solid business opportunities. Venture investing, although initially reeling after the decline at the turn of this
century and the subsequent recession, is recovering. The aging boomers, with their earning and consumption power, continue to provide enduring business opportunities. Many
of the successful entrepreneurial ventures will provide goods and services tailored to this
aging, and wealthy, generation. There will undoubtedly be other business opportunities
..............................
13 Harry S. Dent, Jr., The Great Boom Ahead (New York: Hyperion, 1993). Also see Harry S. Dent, Jr., The Roaring 2000s
(New York: Simon & Schuster, 1998).
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Chapter 1: Introduction and Overview
11
relating to as-yet unlabeled subsets of consumers. Entrepreneurs with the ability to understand demographic shifts, and see the resulting new business opportunities, will write
their own success stories.
CONCEPT CHECK
Q What is meant by the term “baby boom generation”?
Technological Changes
Technological change may be the most important source of entrepreneurial opportunities.14 While the accurate dating of the arrival of major technological innovations is difficult, it is reasonable to say that the genesis of our information society was in the mid to
late 1950s and early 1960s. Transatlantic cable telephone service began. The Soviet Union
launched Sputnik, suggesting the possibility of global satellite communications. Transistors
replaced vacuum tubes in computers. Compilers opened the door to higher-level programming languages, and the development of the computer “chip” was under way.
Perhaps the most important invention in shuttling us from an industrial society to an
information society was the computer chip.15 Such chips are the backbone of all modern
computing and enable the telecommunications applications and information systems that
have changed the way almost everyone lives. The worldwide distribution of computer chips
(and the software systems running on them) has paved the way for what may be the most
significant innovation in global commerce since the merchant ship: the Internet. The Internet is an incredibly diffuse collection of computers networked together. It is hard to think
of anything else in history that parallels the level of international coordination (individuals
and entities) that the Internet has almost painlessly achieved, and in a remarkably short
time.16 When the Internet’s ability to provide nearly instant worldwide communication
was combined with rapid transfer of graphic images, the Internet became the infrastructure
for the “World Wide Web,” a user-friendly and commercially attractive foundation for
many new ways of doing business, including retail and wholesale operations through electronic commerce. In addition to the Web’s commercial applications, the Internet has dramatically changed the way almost everyone goes about daily business. Internet functionality
affects modern life in almost uncountable ways, including such common things as electronic mail (e-mail), remote access, large file transfer (including pictures, music, and
videos), instant messaging, and, more recently, cell phone–Web cross-functionality.
..............................
14 For example, see Scott Shane, “Explaining Variation in Rates of Entrepreneurship in the United States: 1899–1988,”
Journal of Management 22 (1996): pp. 747–781; and Scott Shane, “Technology Opportunities and New Firm Creation,”
Management Science 47 (2001): pp. 205–220.
15 The U.S. Patent Office appears to recognize Jack Kilby and Robert Noyce as the computer chip’s co-inventors. Kilby
conducted research at Texas Instruments during the 1950s and filed for the first “computer chip” patent. Noyce filed
after Kilby, but supposedly had a more useful design. Noyce later cofounded the Intel Corporation. See Lee Gomes,
“Paternity Suits Some Better Than Others in the Invention Biz,” Wall Street Journal, June 18, 1999, pp. A1, A10.
16 The Internet had its beginning in late 1969 when researchers at UCLA, including Professor Leonard Kleinrock and graduate students Stephen Crocker and Vinton Cerf, linked two computers for purposes of exchanging data. This initial
network project, supported by the Department of the Defense (DOD), was given the name Arpanet for Advanced Research Projects Agency Network. Other milestones include the inventing of network e-mail in 1971 and the use of
the “@” symbol in 1972. Cerf and Robert Kan invented the TCP protocol used in transporting data via the Internet in
1974. In 1982, the “Internet” was defined as a series of TCP/IP networks that were connected. In 1990, Tim BernersLee invented the World Wide Web, and Arpanet ceased to exist. The commercial explosion really began after the creation of modern server software, hypertext markup language (HTML), and browsers (such as Mosaic, Netscape, and
Internet Explorer). See Anick Jesdanun, “Happy Birthday to the Internet,” Daily Camera, August 30, 2004, pp. 1B, 5B.
The appendix in this chapter provides further information on the Internet’s structure and the various constituent industries that provide goods and services to support the Internet.
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12
Part 1: Background and Environment
e-commerce
............................
the use of electronic means
to conduct business online
CONCEPT CHECK
Electronic commerce, or e-commerce, involves the use of electronic means to conduct
business online. Although many of the simple “dot.com” and “e-commerce” business
models of the late 1990s did not work, the Internet economy and e-commerce are here
to stay. Simply put, we will never do business the same way we did before the Internet. It
has become too easy to compare various suppliers’ prices or check on the latest offer
from our competitors to return to conducting business in the “darkness” tolerated only
a few years ago. A simple example is online package tracking. Now, instead of using the
phone to say a package is “in the mail,” the sender is expected to provide a tracking
number to be used on the Web so that the sender and the receiver can ascertain the veracity of this claim and follow the package along its route.
Attention continues to shift from the age-old strategy of owning and controlling natural resources (tangibles), to a strategy of owning and controlling information (intangibles). Even Internet entrepreneurs who started their ventures intending to sell products
and services have sometimes found themselves giving their products and services away in
order to monitor their “users” and sell user demographic information. Information is
central in the modern global economy.
While new technologies suggest business opportunities, profitable commercial application of the new technologies often occurs after trial and error. Many attempts to exploit the Internet commercially were proposed, tried, and funded. Eventually, there was
a wave of potentially appealing applications—and the vision was contagious. We are still
trying to determine the winners. That is, we know the Internet provides significant efficiency improvements for commercial interaction; we’re just not sure whether the winners
are buyers, sellers, or both. The Web lets suppliers compete for consumers’ business, putting the consumer in an advantageous position. It is not clear whether this benefits suppliers in the long run.
It is fair to say that many e-commerce business plans were funded with the belief
that part of the benefit could be captured by sellers; that is, producers and retailers.
We now know that the Web so effectively facilitates price competition that it is hard
for suppliers and retailers to protect margins. Much of the efficiency gains go to the
buyers (in what economists call consumer surplus), making for a less-than-attractive
seller business model. Although such a plan might have received funding a few years
ago, building an e-commerce site to sell nondifferentiated goods at lower prices than
are currently available is now a nonstarter. An important characteristic of the Internet
is that physical barriers to entry are very low. That is, it is easy and relatively low cost to
launch a competing Web e-commerce site. If your business model doesn’t have a sustainable purchasing cost advantage, the Internet may help defeat your business model
because it allows scores of other retailers to quickly monitor and replicate whatever
you’re doing and drive everyone toward aggressive price competition and diminishing
margins.
E-commerce may not deliver the margins once conjectured, but the Internet is still
one of the most radical innovations in our lifetime. Expect it to provide profitable new
venture opportunities for many years to come—consumers are probably hooked forever.
Q What innovations drove our move from an industrial society to an information society? Why?
Q Why is e-commerce here to stay?
Crises and “Bubbles”
The first decade of the twenty-first century was characterized by extreme economic
swings accompanied by, among other things, the bursting of several asset and financial
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Chapter 1: Introduction and Overview
13
“bubbles,” the 9/11 terrorist attack on the United States, and the 2007–2009 financial
crisis. Cost-cutting coupled with economic growth during the 1990s led to the availability
of excessive amounts of financial capital as the twentieth century came to an end. Venture investors were chasing poorer investment opportunities than those to which they
had become accustomed. Stock prices of Internet or “tech” firms rose much faster than
those firms’ abilities to generate earnings and cash flows. As a result, the “dot.com” or
Internet bubble burst in 2000.17 Venture funding dried up to at a mere trickle relative
to the amounts flowing during the dot.com era. Many entrepreneurs with good potential
opportunities were unable to find funding.
When the dot.com economy was faltering, an economic recession that began in 2001
was exacerbated by the 9/11 terrorist attack. In response, the Federal Reserve moved
quickly to increase liquidity and lower interest rates. Government spending was increased, and tax cuts were implemented in 2002. Government officials encouraged lenders to make mortgage loans to a wider range of potential home buyers, resulting in
sub-prime mortgages being offered to borrowers who could not afford the loans. Economic expansion and rapidly rising home prices culminated in the bursting of the housing asset bubble in 2006. This was followed by a peak in stock prices in 2007 and an
economic recession that began in mid-2008.
By the second half of 2008, a “perfect financial storm” had been created, and many
worried about the possibility of financial collapse. Several major financial institutions
were on the verge of failing. Some financial institutions were merged into, or acquired
by, stronger institutions (e.g., Merrill Lynch was acquired by Bank of America), the Lehman Brothers investment bank was allowed to fail, while AIG (American International
Group) was “bailed out” by the Federal Reserve and the U.S. government. Venture funding virtually dried up. Even entrepreneurs with good opportunities were stymied by a
lack of venture capital. For the second time in the decade, the availability of venture
funds collapsed.
The U.S. government in October, responded by passing the Economic Stabilization
Act of 2008, which provided funds to the U.S. Treasury to purchase “troubled” financial
assets held by institutions. The American Recovery and Reinvestment Act (ARRA) was
passed in February 2009 and provided for tax incentives, appropriations, and increased
government spending in an effort to stimulate economic expansion.
Importantly for aspiring entrepreneurs, these dark and cloudy times almost always
come with a silver lining. For this most recent financial crisis, it appears that one nascent
sector that benefitted dramatically during the time of crisis was alternative and renewable
energy. Subsidies abounded with project credits, production and investment tax credits,
and loan guarantees.
Additionally, even in the absence of crisis-related government favoritism for certain
sectors, while many entrepreneurs suffer dearly as their ventures fail, others benefit
from consolidation and the resulting lower level of competition due to the shakeout.
Many aspiring entrepreneurs and investor connections are made during the fallout
from major economic crises.
CONCEPT CHECK
Q What asset and financial “bubbles” have occurred recently?
Q What kinds of entrepreneurial opportunities have occurred as a result of government efforts to stimulate the
economy after the 2007–2009 financial crisis?
..............................
17 For an example of the extreme developments see: “10 Big Dot.Com Flops,” http://money.cnn.com/galleries/2010/
technology/1003/gallery.dot_com_busts/index.html, accessed 3/14/2010.
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14
Part 1: Background and Environment
SECTION 1.4
PRINCIPLES OF ENTREPRENEURIAL FINANCE
Entrepreneurial finance draws its basic principles from both entrepreneurship and finance. New ventures require financial capital to develop opportunities, start business
ventures, and create value. It takes time to build value. Investors expect to be compensated for the use of their capital and for the risk that they might not get it back. Developing a successful entrepreneurial venture is best accomplished without the sacrifice of
individual character and reputation. As th...
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